Published January 13, 2015
Rates are rising. If you're thinking about refinancing or taking a second mortgage, read our guide — fast.
THINKING ABOUT CONSOLIDATING some debt or renovating your outdated kitchen? Now's the time to act. Today's low interest rates make home-equity loans and lines of credit an inexpensive way for homeowners to access money.
But the low rates won't last forever. On Wednesday, Federal Reserve Chairman Alan Greenspan warned lawmakers that interest rates are indeed headed higher. Mortgage rates in particular have already begun their ascent, topping 6% this week — the fifth consecutive weekly rise — for the first time since the week of Dec. 3, 2003, according to Bankrate.com. So if you've been debating whether or not to take some equity out of your house, you'd be wise to make a decision soon.
There are three basic ways to tap the equity in your home: Take out a home-equity loan, set up a revolving line of credit or refinance your first mortgage and take out some extra equity at the same time. (This is known as a cash-out refi.) All three mortgage products offer low rates compared with other forms of consumer debt, and in most cases the interest is tax deductible.
Deciding which option is right for you can be complicated, however. All three products have advantages and disadvantages, but they share one thing in common: The home serves as collateral. So if you renege on your obligations, you could lose your house. Don't go into this lightly. (For more on home-equity products, read our primer.)
Here are some pros and cons for each product.
Instant gratification. The beauty of a home-equity loan, also known as a second mortgage, is that at closing the lender hands you a check for the full amount of the loan, which you're then free to spend on anything you wish.
You can write it off. The interest on a home-equity loan is tax deductible, no matter what you spend the money on. There are limits, however. A homeowner can deduct the interest paid on a loan of $100,000 or less, provided the loan amount is less than the property's total value.
Low cost of entry. Closing costs for a home equity loan are tiny — typically just a few hundred dollars, says Vijay Lala, senior vice president of product development for Countrywide Financial. That's a bargain compared with a first mortgage that can easily top a few thousand dollars. Make sure to shop around; some lenders will try to charge extra fees or even mortgage points. (For more on closing costs, read our story.)
It's pricey. Interest rates are typically higher for second mortgages. That's because there's no secondary market for these loans, so lenders must keep them on their books, says Keith Gumbinger, of HSH Associates, a Pompton Plains, N.J., real-estate information firm. The interest rate is typically 2% or 3% higher than the prime rate. The going rate for a $30,000 home-equity loan is about 7.17% (as of April 21), according to Bankrate.com.
There's no grace period. Once you receive the money, you must start making scheduled monthly payments that include both the interest and principal.
Forget flexibility. In most cases, a second mortgage is a fixed loan. If you're a little short one month, don't count on the bank giving you a break. Also, you can't pay down the loan as you can with a line of credit and expect the monthly payments to drop. The monthly payments adjust — that is, stop — only when the loan is paid off in full.
Home-Equity Line of Credit
It's the best deal in town. A home-equity line of credit (Heloc) is a variable-rate revolving line of credit that fluctuates based on the prime lending rate. Since the borrower assumes the risk, lenders charge a very small margin above the prime rate, typically just 0.25% to 0.75%. The prime rate currently sits at 4% and a $30,000 Heloc carries an interest rate of just 4.74% (as of April 21), according to Bankrate.com.
Think of it as a pay-as-you-go plan. As with a credit card, you can borrow money against a credit line as you need it. Not only is this convenient, but it can also save you money. How? You're charged interest only on the money that's actually borrowed. That's why a credit line is recommended for people with ongoing needs like recurring medical expenses or long-term home-improvement projects, says Greg McBride, a senior financial analyst with Bankrate.com. Some financial planners also believe a line of credit is useful in case of an emergency, such as an unexpected job loss.
There's a Heloc for every need. Terms on lines of credit can vary greatly. Some initially charge borrowers interest only, or just a nominal percent of the principal, and eventually put the borrower on a more traditional monthly repayment schedule that includes principal. Other credit lines include a balloon payment made at the end. And some lenders will even allow homeowners to renegotiate the balance of loan when due into a new loan with a fixed-rate monthly payment, says HSH Associates' Gumbinger. Whatever the situation, there's a likely to be a product to fit that need.
The monthly payments could rise significantly. As we mentioned earlier, most lines of credit are variable interest-rate products. That's great when the prime rate is as low as it is today. But when it starts to climb higher, so will the rate on the Heloc. The lifetime cap on many lines of credit is an astounding 18%.
It's not free. Although many lenders don't charge closing costs, there are other fees that borrowers need to look out for. Some banks charge an annual fee of, say, $25, says HSH Associates' Gumbinger. Others may charge an inactivity fee that can run up to $75.
It's awfully tempting to use. Tapping into a line of credit is as easy as writing a check, slapping down a credit card or using an ATM card. So it's not difficult to imagine a homeowner with the best of intentions in the beginning eventually using a Heloc to pay for frivolous indulgences such as a plasma TV or a new wardrobe.
Rates are still favorable. If you haven't already refinanced your first mortgage and locked in today's low rates, do it now. And while you're at it, you can save some money by taking out some equity in your home at the first mortgage's interest rate. Lenders typically charge a lower rate for a first mortgage than for a second lien, says HSH Associates' Gumbinger.
Flexibility. Too many monthly obligations? Consider lowering your monthly payments by extending the terms on your mortgage loan. Even if you can't benefit from lower interest rates, you might still be able to lower your monthly payment by refinancing your mortgage into a new 30-year loan, says Mortgage Bankers Association Chief Economist Doug Duncan.
A loan of last resort. In certain situations, borrowers won't qualify for a home-equity loan or line of credit, says Michael Moskowitz, president of Equity Now, a direct lender based in New York. Homeowners looking to borrow a large sum of money, for example, run into difficulties getting second mortgages or credit lines. The credit limit for Wells Fargo's advertised Heloc, for example, is $250,000. Some self-employed people might also have difficulties qualifying for a second lien. In this case, cash-out refis may be the only option.
High closing costs. Remember how much closing costs amounted to when you first bought your home? Refinancing isn't much cheaper. Homeowners are typically charged 3% to 5% of the total loan amount in closing costs.
Higher total interest payments. By refinancing a mortgage and stretching out the loan over a longer period, a borrower ends up paying more in interest, warns MBA's Duncan. So this may not be a wise financial move for those living in their homes for, say, 10 or 15 years, and who've already paid off a considerable chunk of the principal on the loan.
Slow. It can take a lender 60 days or more to close on a cash-out refi. Even though the borrower already owns the house, the lender still needs to go through the same lending procedures as with a first mortgage. That includes a credit check, home appraisal and title search, among many other things. A home-equity loan, on the other hand, can close in just 10 to 15 business days, says HSH Associates' Gumbinger.